If You're Wondering About Oil Prices, Read This

Dave Forest's picture

Tuesday, January 26, 2016 - 10:30am

by Dave Forest

It's already been a remarkable year so far in 2016 -- especially in the rapidly fluxing oil sector. 

Recently, crude set yet another historical benchmark, slipping below $30 per barrel for the first time since 2003. 

That caps a 70% slide in oil since the most recent peak in mid-2014. 

And the fall has caused havoc in the sector.

The most direct effect of lower crude is falling activity in the exploration and production (E&P) sector. Industry analysts at Baker Hughes reported that the U.S. drilling rig count has now fallen to 664 from 1,750 a year ago. 

Simply put, many of the shale plays that became sweethearts for E&Ps and investors over the past five years are no longer viable. Cash flows are shrinking to the point where many drillers aren't making money pumping crude here anymore. 

Add that to high levels of debt that many E&Ps took on during the good times, and the industry has been hit with a sandbag. 

These days, news of bankruptcies in the sector is coming almost daily. A recent analysis from experts at industry watchdog RBN Energy flagged a slate of 12 companies that are set to become "zombie" firms due to shrinking cash flows and high debt levels. 

These include some of the most prominent names in the E&P sector, such as EXCO Resources (NYSE: XCO) and SandRidge Energy (NYSE: SD). The other companies that made RBN's zombie list: Comstock Resources (NYSE: CRK); Energy XXI (Nasdaq: EXXI); Goodrich Petroleum (NYSE: GDP); Halcon Resources (NYSE: HK); Legacy Reserves (Nasdaq: LGCY); Resolute Energy (NYSE: REN); Sanchez Energy (NYSE: SN); Swift Energy (OTC: SFYWQ); Ultra Petroleum (NYSE: UPL); and W&T Offshore (NYSE: WTI).

All of this suggests that it's a tough time to be an energy investor. 

And I don't believe the situation in regard to oil prices is going to get better anytime soon. 

One of the big reasons is Iran. 

Western sanctions are coming off this former pariah nation for the first time since 2012. And that could add a lot of new crude supply to the global market, relatively quickly. 

Today, Iran likely has 1 million barrels of spare export capacity that could come back on line in short order. 

That's coming at exactly the wrong time. With Saudi Arabia already pumping full out, a jolt of new Iranian crude could force prices even lower than they are now. 

Of course, supply in other parts of the world is now starting to adjust to low prices. U.S. onshore production -- including shale plays -- has been in decline now for several months. In Texas, for example, oil output is down 7% since March 2015. 

That trend is likely going to continue. But at the same time, oil production from the U.S. offshore Gulf of Mexico has actually been rising -- up 20% since last February -- which has kept overall U.S. oil production almost level.

All of this suggests that we're not going to see a big reduction in global supply anytime soon. So there's no obvious relief for prices on the horizon. 

That means we need to be cautious investing in the energy market today -- but we don't need to abandon it entirely. 

Despite all the gloomy news for crude, there are a few trends in motion that are setting select companies up for profits -- such as falling costs in the oilfield drilling industry. 

With drilling activity declining, owners of drilling rigs are being forced to slash their day rates in order to attract the limited business that's left in the sector. And that means lower costs for the firms still drilling new wells.

Such savings on drilling are significant. RBN forecasts that costs for "finding and developing" a barrel of oil equivalent in 2016 will drop to $11 -- a 42% reduction from the $19 per barrel that prevailed in 2014. 

That's a big savings -- and good news for companies working in plays that are still profitable. 

Which plays are those? RBN Energy's experts recently ran the numbers and came up with the chart below, showing profit margins at various shale plays across America, taking into account near-current commodity prices as well as falling drilling and development costs.

As the graphic shows, go-to plays like the Permian and Bakken are still projected to yield double-digit margins if costs fall the way experts expect. So E&Ps working in the core of these plays could turn in a strong performance this year. 

I'm therefore not giving up on the E&P sector completely. But I'm going to be selective in any companies I add to my portfolio. They need to hold the best acreage in the most profitable plays -- and have ultra-low levels of debt. 

As a final note, it's interesting to observe that energy-focused private equity firms in the United States raised $56.9 billion during 2015. There's a huge amount of capital now looking for deals in this industry -- and I wouldn't be surprised to see a surge in M&A this year, as funds scoop up assets with their huge cash troves. 

That could mean profitable buyouts for the E&Ps and midstream firms left standing. Keep an eye on this space. 

Whatever you do, be cautious in energy investing this year -- but don't give up completely. There will be money made in oil and gas during 2016 -- and possibly some big wins, given the low level that most stocks in the space are starting at today. 

P.S. The energy space is tricky for investors right now. So rather than take a risky bet on the sector, I'm advising my readers to look at buying shares of solid companies that dominate their markets, pay increasing dividends and repurchase billions in stock. 

I've even released a special presentation detailing my favorites. One company has paid a growing dividend for over 40 straight years (fewer than 1% of stocks can boast anything close to that kind of safety and growth). To learn more about these top picks for 2016, including several names and ticker symbols, simply follow this link.

Dave Forest does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.